Notice 2023-63: The IRS Defines What Section 174 Capitalization Actually Means

Why this guidance matters

The Tax Cuts and Jobs Act amended IRC § 174 to require capitalizing and amortizing specified research or experimental (SRE) expenditures, effective for tax years beginning after December 31, 2021. The mechanics were clear enough — five-year amortization for domestic costs, fifteen for foreign — but the scope was not. Businesses filed their first returns under the new rule earlier this year facing genuine uncertainty about what counted as an SRE expenditure.

On September 8, 2023, Treasury and the IRS issued Notice 2023-63 to fill that gap. They announced an intent to issue proposed regulations consistent with the notice, and in the meantime set out interim rules taxpayers can use.

The reliance terms are all-or-nothing

The reliance provision deserves precise attention, because it is stricter than a casual reading suggests.

A taxpayer may rely on the interim guidance for tax years beginning after December 31, 2021 — including the returns already filed — but only by applying all of the substantive rules consistently and in their entirety. A taxpayer cannot select the favorable provisions and ignore the rest. There is one carve-out: the disposition rules may not be relied upon for SRE expenditures tied to property contributed to, distributed from, or transferred from a partnership.

This all-or-nothing structure is itself a planning consideration. The notice is not a menu. A taxpayer choosing to rely on it adopts the whole framework.

What is, and is not, a research cost

The heart of the notice is its definition of which costs are SRE expenditures. It provides a non-exhaustive list of costs that must be allocated to SRE activities, including labor, materials and supplies, depreciation and other cost-recovery allowances on property used in research, patent costs, certain facility operation and management costs such as rent and utilities, and travel.

Equally important is the list of costs that are not SRE expenditures. Notably, general and administrative service-department costs that only indirectly support research — the notice gives examples such as payroll, human resources, and accounting functions — are excluded. So is interest on debt used to finance research. So are website hosting fees and the cost of registering a domain name or trademark, along with the amortization of amounts already capitalized under § 174.

The exclusion of indirect general-and-administrative overhead is the answer to one of the most consequential open questions from the first filing season. It draws a line that materially affects how much a taxpayer must capitalize.

Where software development begins and ends

Because § 174(c)(3) treats software development as a specified research activity, the boundary of "software development" controls a large category of costs. The notice defines it.

Treated as software development: planning, designing, building a model, writing and converting source code, and testing to resolve defects — but only up to the point the software is placed in service or, for software developed for sale or license, reaches technological feasibility.

Not treated as software development: purchasing and installing software, employee training, routine maintenance after the software is placed in service that does not produce upgrades or enhancements, and data conversion activities. The line is drawn at the transition from development to deployment, which gives engineering organizations a usable rule for classifying their work.

Who capitalizes research done under contract

Contract research was among the murkiest areas, and the notice supplies a "risks and rights" framework to resolve it.

A research provider has SRE expenditures if either of two conditions is met: it bears financial risk under the contract — the risk of financial loss if the research fails to produce the intended result — or it holds a right to use the resulting research product in its business or to otherwise exploit it through sale, lease, or license. A right available only with the approval of an unrelated party does not count for this purpose. The framework gives parties to a research contract a principled basis for determining which of them must capitalize, rather than leaving it to inference.

The disposition rule, confirmed

The notice confirms a point that surprises some taxpayers. Under § 174(d), if property tied to SRE expenditures is disposed of, retired, or abandoned during the amortization period, no immediate deduction is allowed for the unamortized amount. The taxpayer continues amortizing it over the remaining period. The disposition is not factored into gain or loss. There is a narrow exception when a corporation ceases to exist in a transaction not described in § 381(a). Otherwise, abandoning a research project does not accelerate the deduction.

What this means in practice

Notice 2023-63 converts the first season's open questions into a method a business can actually apply. The defensible course is to evaluate the notice as a whole, decide deliberately whether to rely on it, and — if so — apply its cost-allocation, software, and contract-research rules consistently across the return. Businesses that took conservative or uncertain positions on their first affected return should reassess those positions against the notice now. The IRS requested comments on the issues the proposed regulations will address, which means the framework may evolve; positions taken should be documented well enough to withstand that evolution.

Key takeaways

• On September 8, 2023, the IRS issued Notice 2023-63, the first substantive interim guidance on capitalizing specified research or experimental expenditures under IRC § 174 as amended by TCJA § 13206.
• Taxpayers may rely on the guidance for tax years beginning after December 31, 2021, but only by applying all of its substantive rules consistently and in full.
• The notice excludes from SRE expenditures the indirect general-and-administrative costs (payroll, HR, accounting), interest on research debt, and website hosting and domain-registration costs.
• It defines the boundary of "software development," ending at the point software is placed in service or reaches technological feasibility.
• For contract research, the research provider capitalizes if it bears financial risk or holds a right to use or exploit the resulting product; under § 174(d), disposing of a research project does not accelerate the unamortized deduction.

Frequently asked questions

Can I rely on Notice 2023-63 for a return I already filed?

Yes, for tax years beginning after December 31, 2021, but only if you apply all of the notice's substantive rules consistently and in their entirety. The reliance is all-or-nothing, with a narrow carve-out for certain partnership-related disposition rules.

Does general overhead have to be capitalized under Section 174?

The notice excludes general and administrative service-department costs — such as payroll, human resources, and accounting — that only indirectly support research activities. Those are not specified research or experimental expenditures.

When does software development stop counting as Section 174 research?

It stops when the software is placed in service or, for software developed for sale or license, reaches technological feasibility. Installation of purchased software, training, routine post-deployment maintenance, and data conversion are not treated as software development.

What happens if I abandon a research project mid-amortization?

Under § 174(d) as confirmed by the notice, no immediate deduction is allowed for the unamortized amount. The taxpayer continues amortizing it over the remaining period, with a narrow exception when a corporation ceases to exist.